When you finally give up on collecting a debt (usually it’ll be in the form of a receivable account) and decide to remove it from your company’s accounts, you need to do so by recording an expense. We call this a bad debts expense.
Here, we’ll go over exactly what bad debt expenses are, where to find them on your financial statements, how to calculate your bad debts, and how to record bad debt expenses properly in your bookkeeping.
What is a bad debt expense?
A bad debt expense is a financial transaction that you record in your books to account for any bad debts your business has given up on collecting.
You only have to record bad debt expenses if you use accrual accounting principles. Bad debts are still bad if you use cash accounting principles, but because you never recorded the bad debt as revenue in the first place, there’s no income to “reverse” using a bad debt expense transaction.
Bad debt expenses make sure that your books reflect what’s actually happening in your business and that your business’ net income doesn’t appear higher than it actually is. Accurately recording bad debt expenses is crucial if you want to lower your tax bill and not pay taxes on profits you never earned.
How to find bad debt expense
Like any other expense account, you can find your bad debt expenses in your general ledger.
How to calculate bad debt expenses
There are two ways to calculate your business’ bad debts: by directly writing off your accounts receivable, and via the allowance method.
How to directly write off your accounts receivable
If you don’t have a lot of bad debts, you’ll probably write them off on a case-by-case basis, once it becomes clear that a customer can’t or won’t pay.
In that case, you simply record a bad debt expense transaction in your general ledger equal to the value of the account receivable (see below for how to make a bad debt expense journal entry).
How do you know whether it’s time to write a bad debt off as uncollectible?
According to the IRS, you should only write off a debt once there is “no longer any chance the amount owed will be paid.” You must be able to demonstrate that you’ve “taken reasonable steps to collect the debt.” If you’ve tried (and failed) to contact the customer by phone or set up a repayment plan, it might be time to write off the debt.
How to calculate bad debt expenses using the allowance method
If you do a lot of business on credit, you might want to account for your bad debts ahead of time using the allowance method.
This involves establishing an allowance for bad debts (also called a bad debt reserve or an allowance for doubtful accounts), which is basically a pool of money on your books that you draw from to “pay” for all the bad debts you’ll eventually incur.
Most businesses will set up their allowance for bad debts using some form of the percentage of bad debt formula.
What is the percentage of bad debt formula?
Because you set it up ahead of time, your allowance for bad debts will always be an estimate. Estimating your bad debts usually involves some form of the percentage of bad debt formula, which is just your past bad debts divided by your past credit sales.
The formula is:
Percentage of bad debt = Total bad debts / Total credit sales
Let’s say you’ve been in business for a year, and that of the total $300,000 in credit sales you made in your first year, $20,000 ended up uncollectable. You want to set up an allowance for bad debts to take these bad debts into account ahead of time. How big should the allowance be?
First, you’d figure out your percentage of bad debts:
Percentage of bad debt = $20,000 / $300,000
Percentage of bad debt = 6.67%
If 6.67% sounds like a reasonable estimate for future uncollectible accounts, you would then create an allowance for bad debts equal to 6.67% of this year’s projected credit sales.
If you have $50,000 of credit sales in January, on January 30th you might record an adjusting entry to your Allowance for Bad Debts account for $3,335.
But this isn’t always a reliable method for predicting future bad debts, especially if you haven’t been in business very long or if one big bad debt is distorting your percentage of bad debt.
How to record a bad debt expense
There are two situations in which you’d record a bad debt expense in your books: when directly writing off an account receivable that you’ve deemed uncollectable, and when establishing a reserve for bad debts.
Recording a bad debt expense using the direct write-off method
Let’s say your company, XYZ Inc., wants to directly write off an $800 account receivable that you think is no longer collectible. After calling the customer one last time and getting their answering machine, you would make the following entry in your books:
Recording a bad debt expense for the allowance method
Let’s say that after calculating your business’ percentage of bad debts (see above), you’ve decided to establish an allowance for bad debts account of $2,000 in your books at the end of the month. To do this, you’d make the following entry:
Your allowance for bad debts is a contra-asset account, which means that it will appear on your balance sheet alongside all of your other asset accounts.
Now let’s say that a few weeks later, one of your customers tells you that they simply won’t be able to come up with $200 they owe you, and you want to write off their $200 account receivable.
Because your future losses are already covered by the allowance you set up, you would make the following journal entry: